Inventory Accounting

Companies have a choice as to how they value the inventory they keep. Had Fiji water bottled 4 million bottles of water at a buck each 2 years ago, before the drought...they then have the choice of carrying that inventory value at their book value of $4M...or they could carry them at today’s prices, or market prices, of $2.50 a bottle, or $10M.

So now think about the case where Ray Bans has spent a fortune stocking up on dark, sun-adjusting glass lenses for sunglasses at 50 bucks each, knowing that market prices for them are more like 20 bucks if they had to dump them all today.

The minute they buy the $50 glass lens unit and put it in inventory, they show a notional loss of $30 on that transaction.

Well, if they’ve stockpiled, say, 50 million dollars worth of glass lenses, which they’re holding as being worth 20 million today...but then don’t buy any more lenses for 6 months, letting inventory dwindle from a million units to just 100,000…what happens to their profit margins?

Well, from an accounting perspective, almost nothing. The company used up its stockpile of inventory that it had held at a static price all along. Nothing really changed. They sold their glasses for, say, $80 a unit, and from an accounting perspective, they made a notional $30 per unit, as they depleted inventory.

But what happened to their cash flow levels? If no cash is going out the door to restock inventory, wouldn’t you think cash flow would grow dramatically? Of course it would. The question: how do you account for this relatively sudden change?

Just for clarity’s sake, essentially what Ray Bans will have been doing here is plundering the mountain of sunglasses in those little cheap leather boxes you can never open properly, letting the mountain dwindle down to a molehill as they convert all of that value into cash, and then have no more mountain to go back to, should there be a massive, late-term run on demand for sunglasses from the unholy union of the Krakens and the Hydra.

So that’s inventory as a kind of storage shed of cash for a company…and it applies especially powerfully to products that have no shelf life. Meaning…a pair of dark sunglass lenses don’t go bad in 2 weeks the way a carton of eggs does.

In that case, inventory has a very finite value that decays the moment that inventory is stocked, or laid on the shelves, and companies then have to shell out an allocation for that decline in value.

Regardless, tracking the purchase price, or acquisition price, of that inventory is hugely important when you’re putting together the forensics of a company’s reported earnings...and marking the period-to-period change in that inventory as a driver of cash balances is big as well. Meaning that it’s an awfully low quality cash flow or cash earnings quarter when a company simply grew cash flow because they brought down their inventory from $50 million to $10 million. At some point soon, that well runs dry.